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IAI Actuarial Core Principles · Business Economics · Impact of advertising on sales and demand

In a market for retail banking services, advertising is mainly informative, telling customers about available products, prices and branch locations. Which of the following is the most likely welfare effect of this kind of advertising?

Informative advertising reduces consumers' search costs and makes them more aware of alternatives. This tends to make demand for each firm's product more price elastic, intensifying competition and potentially lowering prices, so it can improve consumer welfare rather than harm it.

  1. AIt makes demand more inelastic and raises the firm's mark-up, with no benefit to consumers
  2. BIt reduces search costs and tends to make demand more price elastic, which can lower pricesCorrect
  3. CIt creates a barrier to entry and always reduces consumer surplus
  4. DIt shifts the supply curve of the industry to the right
  5. It removes all asymmetric information between banks and customers

Explanation

Informative advertising lowers the cost of comparing offers. Customers become better informed about alternatives, so demand for a single firm's product becomes more price elastic and competition can push prices down. Persuasive advertising, by contrast, tends to make demand more inelastic and raise mark-ups.

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